A rough estimate of forward earnings can be produced using the current book vale of PP&E and the net spread over assets metric. Management calculates net spread as basic lease rents minus interest expense over PP&E. Note that “basic rents” is lease revenue excluding maintenance rents and end of lease compensation. Net spread is of course dependent on a number of factors including interest rates, leverage, and depreciation rates (not because depreciation is taken out of the spread but because it affects asset values), but for the most part this metric seems to hold fairly steady over time. Historically, AER has achieved net spreads ranging from 7.5-9.7%, comparing favorably to approximately 7-9% for AYR and FLY. But there is one reason why this calculation might handicap AER. AER has grown assets at a much faster rate than AYR or FLY, and since I’m using end of year assets in my calculation, the full benefit of acquiring those assets will not be reflected in the financial statements.
If asset turnover remains at 12.6%, as it has historically, the leasing business has $960mm of current annual revenue generating power off a current asset base of $7.625 billion. $960mm in revenue lines AER up to hit a 9.2% net spread, just below the target management has set for the year. This compares to basic lease rents of $229 earned in the second quarter, annualized out to $914mm, but keep in mind flight equipment (planes) grew from $7.198B at March 31 to $7.625 by June. If $960 is reasonable, the income statement should resemble the following:
Basic lease revenue: $960 - compare at annualized Q2 basic lease revenue of $914
*SG&A: $140 – High end of mgmt estimate for 2010-2013
*Lease Expense: $82 – High end of mgmt estimate for 2010-2013
D&A: $343 – 4.5% of PP&E. 4% is more likely accurate
* higher than annualized Q2 expenses
4% Interest expense: $256 – Compare to 3.6% in 2Q2010
Interest Income: ($9) – 3% of cash balance
10% Tax: $15 – Mgmt estimated tax rate
Preferred Dividend: $35 – Mgmt estimate
Net Income: $98
Shares: 119mm – Share count after dilution from Genesis Acquisition
Based on this very basic analysis, it already looks like AER is fairly valued for a company that continues to execute well and grow, but we’re excluding some major components. Given that analyst estimates for 2010 have AER generating $1,629mm of revenue, $898 EBITDA, and $1.92 EPS, we know we’ve missed something. So let’s build upon what we already have.
For starters, this analysis excludes maintenance revenues, estimated by management at $65mm/year and management fees of approximately $10-15mm. The costs associated with this operation have already been included in the SG&A expense line. We’re also excluding the AeroTurbine business, effectively an engine chop-shop, which has grown EBITDA from $21.6mm in 2006 to $52.9mm in 2009. We’ll just assume that this low-capital, rapidly growing business will not continue to grow, and that EBITDA represents a stable cash flow to shareholders. Management is expecting AeroTurbine to bring in $200mm of revenue, so we’ll feed that into the top line of our model as well, and make up the difference between that and EBITDA with CoGS. Now the business looks like this:
Lease revenue: $960
Maintenance revenue: $65 – Management estimate
Management fees: $10 – Low end of mgmt estimate
AeroTurbine revenue: $200 – Mgmt estimate
Total revenue: $1235
COGS: $147 – Difference between EBITDA and revenue of AeroTurbine
Lease Expense: $82
4% Interest expense: $256
Interest Income: ($9)
10% Tax: $28
Preferred Dividend: $35
Net Income: $213
It still seems like my revenue, EBITDA, and EPS estimates are a bit low, but we also have to consider the sale of planes out of the existing fleet. Management claims that an appraisal of their planes would value the fleet at approximately an 11% premium to the book value. They have consistently demonstrated that this is likely true by opportunistically selling planes out of the portfolio at a premium to the book value, allowing them to book a profit.
We certainly don’t want to make the mistake of simply applying a normal earnings multiple to this piece of the business unless we’re confident it’s sustainable. To estimate the valuation, we really need to better understand why/how AerCap is able to continually sell planes at a premium to book. There are three possible reasons. One is that they got lucky and either found distressed sellers or anxious buyers and this income is really one-off in nature. The fact that AER has generated significant sales profits every year makes this unlikely. Another possibility can be accelerated depreciation, in which case the sale of planes at real market prices would really just represent AER management reclaiming the book value lost to conservative accounting. Also not the case as AER is selling some of its planes at a profit before they’re even delivered. The final explanation is that they do a good job of understanding the market, understanding valuations, and they opportunistically buy and sell when market values are a bit wacky. Now I know the initial reaction to this statement will be doubt that the market for planes can be inefficient, but I urge readers to consider their chosen professions as a case in point. Good trading seems to me to be the most plausible explanation, and based on the current valuation, we don’t appear to be paying much for it.
Returning to the income statement, management expects sales revenue (excluding AeroTurbine) of $600mm in 2010 and $200mm thereafter. At a below-average margin of 15%, this would boost EBIT by $90mm in 2010 and $30 somewhat continuously thereafter. $200mm compared to the current book value is a portfolio churn of less than 2.6%. Not unreasonable. An extra $27mm (after tax) per year leaves us with the following, indicating to me that the stock has ample room for 100% upside:
Net Income: $240
Just to clarify, I don’t know that this piece of the business will actually be recurring. Even if it is, it will likely be lumpy. However, we don’t need this piece for the investment idea to make sense. Investors should focus on the 7.3x earning they’re paying, and think of this sales piece as a potential bonus.
90% of what I’ve done is based on management forecasts. To some degree, it coincides with analysts, but more importantly it coincides with historic performance. Comparable companies AYR and FLY are trading at 9.2x and 10.3x 2010 estimates (from Bloomberg) respectively.
CaveatsOne way to explain what I see as a potential misvaluation is to consider the fact that AER is more leveraged than its competitors. If we consider an EV (including minority interest) to basic lease rent ratio, AYR and FLY are trading at about 6x whereas AER is trading around 8.5x. Using the EBITDA number estimated above (excluding the sales piece) AER is trading at around 9.1x EV/EBITDA compared to 6.1 and 7.8x for AYR and FLY respectively. Factoring the D&A back in, we can estimate a cap rate of 6.7%, 9.7%, and 7.2% for AER, AYR, and FLY respectively. One could easily make the argument based off this that AYR is the most undervalued. If this was a chapter 11 situation, I would agree. Or if I believed that AYR or FLY would draw on that “available capital” to fuel future growth, I might change my mind. But AER appears to have maintained the most consistent capital structure, shareholders benefit from the growth opportunities it affords, and current debt levels don’t appear unsustainable. More importantly, I appreciate management’s willingness to grow the balance sheet when asset prices are depressed. If AYR and FLY decided to lever-up and grow the business, they might have already missed the prime buying opportunity that AER capitalized on. Shareholders should benefit from this, even if AER spends some time deleveraging in the coming years.
There are other risks as well. For example rising interest rates could pressure the bottom line, but even that increases costs for airlines looking to finance their own purchases, so to a large extent financing costs are externalized. The trick is to match liabilities to assets in terms of duration and exposure to floating interest rates, which AER seems to have done a good job of. That job will get easier as the securitization market recovers, and it’s entirely possible that AER will be able to securitize a large pool of assets locking in attractive 30 year financing. Falling fuel costs could also be a risk to AER as most of their planes are newer and more efficient. Falling fuel costs would bring excess idled capacity back into the market and potentially make newer planes less economically justifiable. However, these costs are passed on to passengers (and shippers), meaning that falling fuel prices will increase demand and increase the volume of traffic. Again it seems like negative feedback loops stabilize the leasing business model.
So in conclusion, it seems like AerCap has performed well and the share price is attractive. Naturally there’s quite a bit of leverage at work here, so minor variations in my assumptions can have a significant impact on the bottom line. I’ve been careful, but obviously readers will have to work through the numbers and financial statements on their own.
Disclosure: Long AER